The Laffer Curve: Study with Video Lessons, Practice Problems & Examples

The Laffer Curve illustrates the relationship between tax rates and tax revenue, showing that higher taxes do not always lead to increased revenue. Initially, as tax rates rise, revenue increases until reaching an optimal point, after which further increases can decrease revenue due to reduced quantity exchanged. This concept highlights the balance between tax size and economic activity, emphasizing that excessive taxation can lead to diminished returns and economic inefficiencies, such as deadweight loss and reduced consumer surplus.

Laffer Curve

So the government needs to collect more tax revenue. What do they do? They raise taxes. Right? But that doesn't necessarily lead to more tax revenue. We can actually find a pretty interesting conclusion when we use what's called the Laffer curve to show us how higher taxes do not necessarily mean more tax revenue. Let's check it out. So like I said, this larger tax does not necessarily lead to higher tax revenue. Why is that the case? Well, remember as the size of a tax increases, how do taxes affect our quantity exchanged? As we have more tax, well, that's more cost here, right? So it's going to keep decreasing the quantity exchanged, right? The quantity exchanged is going to decrease as the tax increases. So as we learned here with taxes in our other videos, let's go through three examples here where we'll have a small tax, a medium-sized tax, and a large tax, and let's see how that affects tax revenue. As you remember, we can represent the size of the tax by the space between the demand curve and the supply curve. So if this is our demand, our downward demand, upward supply, and let's say this green line right here let's start with a we'll do extremes. We'll have a very small tax here. So if we have a very small tax here, right, and this would be the size of the tax. So if we were at this point, this would be the quantity exchanged if we had that size check size tax. So I'll put qt with the tax, right, where we would originally be at this equilibrium over here, but the tax, it moves us away from equilibrium because the, the price that the suppliers receive and the price that the buyers pay is now different because of the tax, right? So what's going to happen in this case? Remember how we calculate our tax revenue? Well, it's the amount of tax times the quantity exchanged, right? We're dealing with per-unit taxes here. So if we're going to exchange this quantity and there's a certain amount of tax say $1, let's say this is a $1 tax, well, the amount of tax revenue would be represented by this box here, right, because if we go to the the demand curve here, this is the price that the buyers pay and this down here is the price the sellers receive. Right? Everything in the middle goes to the government. So what we'll see here is that this space here, just like we saw when we studied taxes originally, this is the amount of tax revenue. So this is our tax revenue in this little box here. Right? So notice, there's a small tax revenue here because we have a small tax. Now, let's go to the other extreme. Let's go to where we have a really large tax. Okay? Let's start here on this bottom one where we have a really large tax. Let's do the same thing. Right? And now, let's say the tax is this big amount over here. Way over here, there's this huge tax. Maybe $15 per item where before it was just $1. Right? So now, we've got this $15 tax per item and notice what's happened to the quantity exchanged. In this case, the quantity exchange is going to be way down here, with the quantity with the tax. Yeah. Our quantity exchanged has decreased a lot because there's a big tax here. So now the price the buyers pay is way over here. So notice, there's not so many people that wanna pay this high price. There's not going to be that much exchanged. This is our demand curve, our supply curve, and this is the quantity, supplied down here because this is the price that the sellers receive and there's not that many sellers that wanna supply at such a low price received. Right? So notice what our tax revenue here is. Even though there's this big amount of tax, right, they're getting a lot per exchange. Well, there's not so many exchanges happening now. So what happens to our tax revenue? Well, it's this space again. The space of the tax the amount of the tax times the, the quantity exchanged. So again, notice what our box looks like. So our this the area of the box hasn't increased very much or is pretty much the same as when we had the small tax up here, right? In this case, notice we had a very long box but not very tall. In this case, we have a very tall box but it's not very long. So the area of the box has not changed very much. So even though this is our kind of an example here, you can kinda see where I'm getting at. So our tax revenue there is still not much different than when we had a small tax. Now let's go to the situation where we have maybe a more ideal tax somewhere in the middle. So let's see what happens if we have maybe this tax right here. Maybe this is a better tax for the government right here. So something in the middle. Again, we have a quantity exchanged that's going to be right here with the tax. And what's going to happen with the price the buyers pay and the price the sellers receive? We're going to have this as our demand curve, our supply curve here. So this is the price the buyers pay, the price the sellers receive, and notice what's happened to the area of the box. There's a lot more area here. Right? And that's the idea with a medium-sized tax, the correct-sized tax. Now in every market, this could be a different amount, right? We can't say what the correct tax is that's going to maximize tax revenue, in any market just like this. But this is the idea where there's more tax revenue when there's the correct tax because notice what's happened in this case. There's still quite a lot of quantity being exchanged because we're not in those extremes, but there's also a sizable tax revenue. So the length of the box and the width of the box is greater and that leads to a higher area which leads to higher tax revenue here. So, the tax revenue, we're going to say, is the biggest when we have that medium-sized tax. So what is the Laffer curve? How do we translate this all onto a graph to let us know, what the proper tax revenue or what the proper size of the tax is? So the Laffer curve, what it shows us let me get out of the way a little more. What it shows us is that we've got if we put the size of the tax on the x axis here and we put the tax revenue, the amount of tax revenue received by the government on the y axis, well, when we as we increase the tax, right, we're getting more and more revenue up to a point where the tax has gotten too big and the revenue is going to start decreasing again, right? So if we start with the small tax up here, we're going to have a small amount of revenue and it's going to start increasing and increasing as we reach the perfect amount of tax for the maximum tax revenue and then it's going to start and that's here in the medium graph and then it's going to start decreasing again as we get to the large graph, the area of the box gets smaller and smaller again. Right? So notice, our Laffer curve is going to look something like this then. As the size of the tax increases, what we're going to have an increase in tax revenue until it reaches some sort of maximum like that at that ideal maximizing tax revenue tax and then it's going to start decreasing again. Right? So we're going to have this kind of parabolic shape where we're going to have, the tax revenue increasing to a point and then it starts decreasing again. So what does this tell us? That higher taxes do not necessarily lead to more tax revenue because the quantity exchanged is going to keep decreasing as those taxes increase. Okay. So that's what this Laffer curve is depicting. It's depicting the relationship between that size of the tax and the amount of tax revenue and it's named after Arthur Laffer. That's the guy who created this idea, creator of the Laffer curve and he suggested that the USA was already on the downward slope of the curve. So he's saying that the USA was already somewhere, let's say here on the curve. Maybe the USA is right here. So any increase to taxes was actually going to decrease tax revenue. Okay? Now we don't know if he's right or wrong, but the idea is that he was proposing that as we increase taxes, it's actually going to hurt our tax revenue because it's going to hurt the quantity exchanged. So in this situation, what it's saying is that larger taxes are going to have multiple negative effects. First, we're going to have less quantity exchanged less quantity exchanged which is also going to lead to less tax revenue, right? Just as we saw in our examples there, we're already at that large tax. So if we were to increase the tax even more, that tax revenue would the total tax revenue would decrease. Cool? So that's about it for the Laffer Curve. That's what you have to remember here that it's a relationship of larger taxes and the amount of tax revenue. Cool? Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the Laffer Curve and how does it relate to tax revenue?

The Laffer Curve illustrates the relationship between tax rates and tax revenue. It shows that initially, as tax rates increase, tax revenue also increases. However, after reaching an optimal point, further increases in tax rates can lead to a decrease in tax revenue. This is because higher taxes can reduce the quantity of goods exchanged, leading to lower overall economic activity. The curve highlights the balance between tax size and economic activity, emphasizing that excessive taxation can lead to diminished returns and economic inefficiencies, such as deadweight loss and reduced consumer surplus.

How does the Laffer Curve explain the impact of high taxes on economic activity?

The Laffer Curve explains that high taxes can negatively impact economic activity by reducing the quantity of goods exchanged. As taxes increase, the cost to consumers and producers also rises, leading to a decrease in demand and supply. This reduction in economic activity results in lower tax revenue, despite the higher tax rate. The curve suggests that there is an optimal tax rate that maximizes revenue without significantly hindering economic activity. Beyond this point, further tax increases can lead to reduced economic efficiency and lower overall tax revenue.

What are the key points on the Laffer Curve?

The key points on the Laffer Curve include: 1) The initial upward slope, where increasing tax rates lead to higher tax revenue. 2) The peak or optimal point, where tax revenue is maximized. 3) The downward slope, where further increases in tax rates result in decreased tax revenue due to reduced economic activity. These points illustrate the balance between tax rates and tax revenue, emphasizing that there is a limit to how much revenue can be generated through taxation before it becomes counterproductive.

Who created the Laffer Curve and what was its original purpose?

The Laffer Curve was created by economist Arthur Laffer. Its original purpose was to illustrate the concept that there is an optimal tax rate that maximizes government revenue. Laffer suggested that beyond this optimal point, higher tax rates would lead to a decrease in tax revenue due to reduced economic activity. The curve was used to argue that lowering excessively high tax rates could potentially increase total tax revenue by stimulating economic growth and increasing the quantity of goods exchanged.

How can the Laffer Curve be used to determine the optimal tax rate?

The Laffer Curve can be used to determine the optimal tax rate by analyzing the relationship between tax rates and tax revenue. By plotting tax rates on the x-axis and tax revenue on the y-axis, the curve shows that revenue increases with tax rates up to a certain point. The peak of the curve represents the optimal tax rate, where revenue is maximized. Beyond this point, further increases in tax rates lead to a decrease in revenue. Policymakers can use this information to set tax rates that maximize revenue without significantly hindering economic activity.